Tuesday, 10 July 2018

As part of this author’s research on the Principles for Responsible Investment,
the concept of ESG consideration has been analysed in relation to its
importance to development of more forward-looking and sustainable investment
practices. In this post, we will look at whether Environmental, Social, and Governance’
(ESG) principles are followed in full, or whether there is still some resistance
to incorporating all of the concept.
There is a suggestion that only certain elements are ‘material’, but recent
news suggests that it is sometimes, or even often, unwise to separate the three
components.

In reviewing the two particular reports generated by the PRI
concerning the impact of ESG on credit analysis (the first one is available here,
and the second here),
it quickly becomes apparent that, for the Credit rating agencies (CRAs), the
concept of ‘G’overnance is the most material aspect. Yet, the CRAs make a point
of the Volkswagen
emissions scandal to demonstrate where the different elements of ESG
converge, with that case in particular covering aspects of Governance (via poor
management practices), Environment (via environmentally-concerned regulations),
and the wider impact upon Society. This focus is valid, but within the reports
this situation is held up as a somewhat solitary event. Just a couple of weeks
since the last report was published, the automobile industry is facing another
scandal with the news that Nissan, Japan’s second largest automobile company,
has been falsifying its
emissions-related data.

The first point to note is that the business media are
almost unanimous in suggesting that this case is not exactly the same as the VW
case. The suggestion is that Nissan have fallen foul of poor
practices across their manufacturing operations, with certain tests falling
short of the prescribed requirements imposed by Japanese regulators – as opposed
to VW, who were found to be including emission-altering recording software in
their vehicles. This narrative falls in line with previous issues at Nissan
relating to safety concerns and practices which resulted in a recall of 1.2
million cars last year. However, Nissan has confirmed that emissions data was ‘deliberately
altered’, and that news has had an immediate and significant effect upon
the company’s position. In response, Nissan has initiated internal
investigations which it says will consist of ‘a
full and comprehensive investigation of the facts… including the causes and
background of the misconduct’. There has been little to suggest, so far,
that the company will find itself embroiled in a scandal the size of VW’s, but
these news does signal that focusing upon the entirety of ESG as a concept is
important, as many investors have been calling for.

The CRAs, who exist to provide an opinion on the
creditworthiness of a given entity, are in complete agreement that governance
is the key factor. There are a number of reasons for this, but the main reasons
are that the management of a company will often have direct impact upon the
company’s creditworthiness, and that the governance of a company can be made
much more quantifiable than the other elements within ESG. This, of course, is
not invalid, and it is not a surprise to hear that the CRAs want to focus upon
what can be quantified. However, whilst Governance is obviously a massive
factor in the Nissan case, the other elements of ESG are all present, meaning
that this story (in addition to the VW scandal), is a shining example of the
interlinking properties of the concept of ESG. Furthermore, there is perhaps a
fear that these stories represent a trend,
which makes ESG analysis even more valuable. In the Nissan case, the ‘E’ is
represented by the regulations designed to enforce environmentally-concerned
standards, and the ‘S’ essentially informs the ‘E’ policies – the standard-setting
in this industry is not just in relation to environmental concerns, but also is
in relation to consumer habits, the impact of a degrading environment, and the
direction of society towards a more renewable sentiment.

The implications of the Nissan story will be felt for some
time, and it is likely that Nissan will not be the last automobile company to fall
foul of emissions regulations. The issue is that these factors are only slowly
coming to be recognised by the financial sector, with traditionalist viewpoints
maintaining in the face of mounting evidence that a dynamic and more
forward-looking focus is required. The story represents a clear demonstration
that finance needs to respond to the changing, and more ‘ethically’ concerned
society. However, this term is problematic in that it describes processes which
are moralistic in nature. It is mostly for this reason that the PRI has decided
to attempt to take the world of ‘ethical’ finance, or more accurately ‘sustainable’
finance, more mainstream so that the impact of changes in the field will be
more widespread; news like that from Nissan will only help to demonstrate why
that is a worthwhile endeavour.

Tuesday, 3 July 2018

Today’s post reacts to the news that PricewaterhouseCoopers
(PwC) has been fined a record amount by a US Court in Alabama over its role in
the collapse of Colonial Bank. The reaction to the news, and what it may mean
for other regulators (who are currently in the limelight for their soft-touch
approach) will be discussed in this post, with the sentiment being that this
action is just a step in the right direction, but nothing more (for a number of
reasons).

Originally, the Judge presiding over the case had accepted that
PwC were ‘duped by
a determined gang of fraudsters’, but ultimately declared that,
irrespective of this, PwC still fell short of its professional responsibilities.
Specifically, the Court ruled that the auditor had demonstrated ‘negligence’
when it failed to perform the adequate checks, and as such the FDIC were
entitled to be compensated for being on the hook for the collapse of Colonial.
Although this author, as many of the regular readers of Financial Regulation Matters will know, is no fan of the financial
penalty system (over custodial sentences), this does appear to be a positive
step in the fight against the oligopolistic dominance of the Big Four auditors;
after all, this fine represents the largest fine on record for an auditor
(taking into account the differences between a fine and a settlement, of
course). Yet, here in Financial
Regulation Matters we are constantly proposing that we need to assess these
situations in reality, and not as one
may want them to appear, and in this instance that viewpoint is particularly
useful. Initially, and rather predictably, PwC have announced they will appeal.
This of no great surprise, but what will be more impactful is their oligopolistic response, which was
confirmed by a Lawyer who represents the firm when he stated that the judgment
will ‘greatly increase’ audit costs, and that ‘auditors
have to charge enough of a fee to account for claims like this’. The
inference in this statement is abundantly clear: “if you come for us, we make
everybody pay”. This is the typical response from an oligopolistic member, as
they fully internalise the influence that comes with being a member of an
oligopoly. Furthermore, it is likely that PwC will use this instance as a
deterrent to other regulators not to be so zealous, and with that in mind we
have a tremendously apt example.

Across the Atlantic, British regulators have more than
heeded that warning (if they were ever capable of doing so in the first place).
The besieged Financial Reporting Council (FRC) is currently undertaking a
number of investigations into audit firms, including Deloitte
and KPMG.
In attempting to respond to parliamentary pressure for its ‘passive and
reactive’ approach to regulation, the FRC is investigated KPMG for its auditing
of the failed drinks supplier Conviviality. This comes after a string of
actions, including PwC’s audit of failed retailer BHS (which resulted in a
record £6.5 million fine), although the underlying inference is that the FRC is
still reactionary, just now it is reacting to Parliamentary pressure and the looming
Kingman Report. Unfortunately, the recent decision in the US provides for
an uncomfortable comparator for British regulators.

The difference between record fines of $625 million and £6.5
million are stark, irrespective of the different scales. Whilst the US is
obviously a larger entity than the UK, the damage caused by the auditors and
their ‘negligence’ is just as severe and widespread, so why the difference?
Professor Prem Sikka, who will be leading the Labour
Party’s review of the industry, commented via his Twitter
account that ‘fines [in the Conviviality case], if any are levied, will be
passed to the ICAEW. What a circus’. The FRC, in its March 2018 Budget and
Levies strategy report, state that ‘If
the FRC’s audit investigation and sanctions work results in a statutory fine
under the Statutory Auditors and Third Country Auditors Regulations 2016
(SATCAR), that fine would be required by those regulations to be paid to the
Secretary of State’ – presumably the Conviviality fine would be established
under those regulations, but only time will tell if this ends up being the
case. Yet, the real issue is this one ‘toothlessness’ described by
Parliamentary Committees, and these reactions by the FRC only support these
claims, despite what they may think. In reality, if the FRC was confident that their regulatory approach
was the correct one, they would not bow to the external pressure. It is also telling
that their response to that pressure
has been to raise their fines to ‘record’ levels, all of which constitute the
smallest of fractions of the auditors’ operations. Ultimately, the UK is in
real danger of being regarded as a particularly light-touch jurisdiction when
it comes to financial regulation, and in the post-Brexit arena this will have disastrous
consequences; the race-to-the-bottom will have many losers.

Contributions are welcome to this blog. If you would like to contribute regarding any area of financial regulation, then please feel free to email me and submit your blog entry. The content should be concerned with financial regulation, and why it matters, but this is broadly defined. The blog is open to all who are professionally concerned with financial regulation, which may range from an Undergraduate Student interested in writing on the subject, to Professors and industry participants.